Breaking news: Regulators are (re)discovering that maybe speculation CAN be excessive

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The announcement this morning (pdf!) by Commodity Futures Trading Commission chairman Gary Gensler that his agency is considering imposing limits on the size of trades by energy futures speculators may amount to something of a landmark (or turning point, or whatever portentous phrase you prefer) in Washington’s relationship to financial markets.

Gensler justified the move as part of the CFTC’s duty “to eliminate, diminish or prevent the undue burdens on interstate commerce that may result from excessive speculation.” This is a big deal because, for the past 40 years, financial regulators have increasingly gravitated toward the position that speculation can never be excessive. As an official in the Clinton Treasury Department in the late 1990s, in fact, Gensler helped fight off efforts by then-CFTC chairman Brooksley Born to rein in what she felt was excessive speculation in over-the-counter derivatives markets. Yet now here he is proposing new rules to rein in oil and natural gas speculators.

The roots of the benign attitude toward speculation that prevailed in recent decades can be found (among other places I’m sure, but those places aren’t on my bookshelf) in a famous 1953 paper by Milton Friedman on “The Case for Flexible Exchange Rates” (which in turn can be found in his book Essays in Positive Economics). The basic thrust of the paper—that anything but a permanently fixed exchange rate or a free-floating one is inherently destabilizing—still holds up reasonably well. But I’m not so sure about this passage on speculation:

People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency is low in price and buy when it is high.

Maybe it’s the “in general” that’s the problem here. On average and over time, the argument may be right. But there are surely extended periods during which price bubbles persist—as in the oil futures market last year—and speculators make lots of money by betting on further price increases, thus destabilizing markets. So Gensler is proposing rules that would limit just how much speculators can bet energy price movements, to rein in those wild price movements.

This is of a piece with a speech made a couple weeks ago (via Simon Johnson via Kevin Drum) by Tim Geithner’s successor at the Federal Reserve Bank of New York, Bill Dudley (who, like the CFTC’s Gensler, is a Goldman Sachs alum). Said Dudley:

1. Asset bubbles may not be that hard to identify—especially large ones. For example, the housing bubble in the United States had been identified by many by 2005, and the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007.
2. If one means by monetary policy the instrument of short-term interest rates, then I agree that monetary policy is not well-suited to deal with asset bubbles. But this suggests that it might be better for central bankers to examine the efficacy of other instruments in their toolbox, rather than simply ignoring the development of asset bubbles.
3. If existing tools are judged inadequate, then central banks should work on developing additional policy instruments.

Let’s take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep “skin in the game”, I think the housing bubble might not have been so big.

I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier.

This may be the emerging orthodoxy: Speculative bubbles are real, and we can do something about about them. What exactly that something will be is still—apart from, it appears, position limits for oil futures traders—very much up in the air.

Update: Robin Hanson has a different (and, as always, provocative) take on all this.

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